With the US government issuing trillions of dollars worth of bonds to support its COVID19 response program, investors like Erik Schiller, managing director at PGIM Fixed Income, are snapping up price dislocation opportunities.
Schiller, who looks at highly liquid non-credit instruments in developed markets and mortgage backed securities, outlined his main relative value investment strategies in an interview with Investment Magazine’s Market Narratives.
“Identifying cheap and rich securities is only the beginning of the process,” Schiller said. “The difficult part is deciding which pricing discrepancies have near-term catalysts to move these valuation anomalies back in line.”
Schiller and his team focus on identifying the fundamental mathematical dislocation and what the other qualitative forces that would cause those dislocations to converge. Once they have a picture of the opportunity, and understand the level of opportunity, they concentrate on structuring risk and trade sizing around those dislocations. Schiller will be speaking Investment Magazine’s upcoming Absolute Returns Conference on September 23-24 on the topic ‘Structural inefficiencies and relative value fixed income’ – register for the event here.
Schiller often employs a government bond relative value strategy which exploits valuation discrepancies between fixed income securities, like yield curve arbitrage, swap spread arbitrage, mortgage arbitrage, volatility arbitrage, and credit arbitrage.
“Time is the number one ingredient in all of this,” Schiller said. “Bonds that are fundamentally cheap tend not to stay cheap, they tend to mean revert over time. Similarly bonds that are fundamentally rich, they also mean revert over time.”
These structures can offer positively skewed returns with little correlation to other asset classes, Schiller said, adding the direction of yields doesn’t matter greatly in this approach.
“It’s the inherent idiosyncratic differences in relationships between comparable securities which we think will mean revert over time,” Schiller said. “And these can be created just by higher volumes and wider interest rate ranges.”
Another strategy is the mortgage value relative trade, where investors buy mortgage coupons that are fully backed by the US government. Each coupon has different characteristics, such as when the mortgage originated and the payment characteristics, allowing investors to find mispricings should those characteristics change from their original circumstance.
“We use a valuation framework, in terms of option-adjusted spreads that tells us which coupons in which cohorts might be fundamentally rich or cheap,” Schiller said.
While lightning fast computational power and high frequency trading is on the rise, Schiller noted the mean reversion time is actually coming slower than it was before the Global Financial Crisis in 2008.
“Prior to the regulatory impingement on banks after the GFC to limit proprietary trading and leverage, there was a much larger pool of capital taking advantage of these dislocations,” he said.
“Those entities were delivering handsome returns to shareholders because of their relative value trading operations.”
But Schiller said the regulatory overhang has taken banks like Goldman Sachs and Morgan Stanley out of the return seeking trades, the arbitrage trades and the dislocation trades, which are similar to today’s relative value strategies.
“That’s left it to the remaining capital pool of hedge funds to arbitrage those dislocations, and they have to have time horizons that are a little bit longer,” Schiller said.
To best take advantage of these opportunities, Schiller said firms need to have a significant leverage factor, of between 10 and 30 turns, which is often a barrier to entry for those wanting to step into systematic and repeatable strategies like this.
“The scope of these opportunities is extracted on average on an annualised basis of half a point of price deviation,” he said. “That’s around a 50 basis point price deviation.”
As an example, Schiller calculated a 10 leverage factor would generate 5 per cent gross return on equity to the investor, with a 30 turn leverage receiving a 15 per cent return on equity.
However investors hoping to capitalise on mispriced opportunities within markets need to stay aware of how volatility can disrupt modelling.
“Lower levels of volatility lead to smaller levels of dislocation and bigger tail risks when those dislocations become larger,” Schiller said, adding it is important to always have a stopping point, an understanding of your time horizon and a historical perspective.
“These are very fruitful trades, but developing a track record takes access to significant leverage and if you have to borrow money from an investment bank then it becomes much harder to implement these strategies.”
In March, when it became clear the global economy would shutter due to COVID19 and there was turmoil in financial markets, many investors poured into the US mortgage market as a source of liquidity, pushing valuations sharply down.
“That liquidity stress caused some fat tail observations in some of these relative value strategies,” Schiller said.
“So having a historical perspective of how dislocated some instruments can get as well as a time convergence that allows you to hold that position and force the trade to come back into line.”